Question

You are using the CAPM to estimate the cost of equity for a security. You use the 10 -year Treasury bond to estimate the risk-free rate. You estimate the return on the market using returns from the S\&P 500 over the past 5 years. You estimate beta using six different services and take the average of the six. Your risk-free rate estimate is 2%, your return on the market estimate is 17%, and your beta estimate is 1.2 . Assuming your estimates are accurate, will the CAPM result in the appropriate cost of equity for your valuation? Why? (You should be able to answer this question in no more than two sentences.)

Answer 1

Yes, the CAPM will result in an appropriate cost of equity for valuation, as it incorporates the fundamental inputs of risk-free rate, market return, and beta to calculate the expected rate of return given the risk.

Step-by-step explanation:

Assuming the estimates are accurate, the Capital Asset Pricing Model (CAPM) will yield an appropriate cost of equity for valuation because it incorporates the risk-free rate, the expected market return, and the security's systematic risk through beta.

In this case, using a risk-free rate of 2%, a return on the market estimate of 17%, and a beta estimate of 1.2, the expected rate of return on the equity can be calculated, which provides an insight into the security's cost of equity considering risk and return dynamics of the market and the particular security.